523 F.3d 461 (4th Cir. 2008), 07-1177, BB&T Corp. v. United States

Docket Nº:07-1177.
Citation:523 F.3d 461
Party Name:BB&T CORPORATION, Plaintiff-Appellant, v. UNITED STATES of America, Defendant-Appellee. Equipment Leasing and Finance Association, Amicus Supporting Appellant.
Case Date:April 29, 2008
Court:United States Courts of Appeals, Court of Appeals for the Fourth Circuit

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523 F.3d 461 (4th Cir. 2008)

BB&T CORPORATION, Plaintiff-Appellant,


UNITED STATES of America, Defendant-Appellee.

Equipment Leasing and Finance Association, Amicus Supporting Appellant.

No. 07-1177.

United States Court of Appeals, Fourth Circuit.

April 29, 2008

Argued: Feb. 1, 2008.

Appeal from the United States District Court for the Middle District of North Carolina, at Durham. N. Carlton Tilley, Jr., District Judge. (1:04-cv-00941-NCT)

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[Copyrighted Material Omitted]

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William Kearns Davis, Bell, Davis & Pitt, P.A., Winston-Salem, North Carolina, for Appellant.

Judith Ann Hagley, United States Department of Justice, Tax Division, Washington, D.C., for Appellee.


Alan M. Ruley, Bell, Davis & Pitt, P.A., Winston-Salem, North Carolina; Robinson B. Lacy, Andrew S. Mason, Ann McLean Jordan, Sullivan & Cromwell, L.L.P., New York, New York, for Appellant.

Anna Mills Wagoner, United States Attorney, Greensboro, North Carolina; Richard T. Morrison, Acting Assistant Attorney General, Gilbert S. Rothenberg, Acting Deputy Assistant Attorney General, Richard Farber, United States Department of Justice, Tax Division, Washington, D.C., for Appellee.

Steven E. Grob, Edward A. Groobert, Anthony Ilardi, Jill M. Wheaton, Dykema Gossett, P.L.L.C., Bloomfield Hills, Michigan, for Amicus Supporting Appellant.

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Before WILLIAMS, Chief Judge, WILKINSON, Circuit Judge, and PATRICK MICHAEL DUFFY, United States District Judge for the District of South Carolina, sitting by designation.

Affirmed by published opinion. Chief Judge WILLIAMS wrote the opinion, in which Judge WILKINSON and Judge DUFFY joined.


WILLIAMS, Chief Judge

This appeal requires us to determine the tax consequences of a complex financial transaction. BB&T Corp. entered into a "lease-in/lease-out" transaction, often called a "LILO," hoping to reduce its tax liability, but the Internal Revenue Service ("IRS") disallowed the deductions it claimed. After BB&T sued for a refund, the district court granted summary judgment in favor of the Government.

BB&T now appeals, arguing that the district court misapplied the "substance-over-form" doctrine in determining that it could not claim deductions for rent and interest under 26 U.S.C.A. §§ 162(a)(3) & 163(a) (West 2002 & Supp. 2007). Specifically, BB&T disputes the district court's conclusion that although the form of the transaction involved a lease financed by a loan, BB&T did not actually acquire a genuine leasehold interest or incur genuine indebtedness as a result of the transaction. For the following reasons, we affirm.


Because this is an appeal from the district court's grant of summary judgment in favor of the Government, we review the facts in the light most favorable to BB&T. Anderson v. Liberty Lobby, Inc., 477 U.S. 242, 255, 106 S.Ct. 2505, 91 L.Ed.2d 202 (1986).

A. Background.

The parties agree that the structure of the transaction at issue matches that of a "typical" LILO, so we begin with a brief overview of this complex transactional form.

In a typical LILO, a U.S. taxpayer leases property from a tax-exempt entity and simultaneously leases that property back to the owner. The tax-exempt owner's sublease has a shorter term than the taxpayer's lease. Upon expiration of the shorter sublease, the owner may exercise an option to buy back the remainder of the taxpayer's lease. Thus, in practical terms, the tax-exempt property owner continues to use the property during the sublease term just as it did before the transaction and bears no risk of losing control of its asset(s).

The taxpayer, meanwhile, receives tax benefits by deducting the rental payments on its lease, amortizing certain transaction costs, and, depending on its financing arrangement, deducting interest payments. Maxim Shvedov, CRS Report for Congress: Tax Implications of SILOs, QTEs, and Other Leasing Transactions with Tax-Exempt Entities 8 (2004). The tax benefits can be substantial and are achieved primarily by "[a]ccelerating the transaction-related deductions and delaying recognition of the corresponding revenues." Id. at 3. This delayed recognition creates a tax deferral, which, in practice, will function as a tax reduction due to the time value of money. Id. at 2, 8.

Generally, parties aim to structure a LILO in a way that essentially eliminates any risk of economic loss while maximizing the deductions that the taxpayer may claim. In this respect, the parties strive to "strike a balance between limiting their exposure to risks on one hand, and making sure the provisions do not disqualify the

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transaction as a [genuine] lease [for tax purposes] on the other". Id. at 9; see also Mark P. Gergen, The Logic of Deterrence: Corporate Tax Shelters, 55 Tax L. Rev. 255, 259 n.19 (2002) (noting that LILOs are often structured so that "there is no risk to any party, other than the tax law risk").

The chief tax risk associated with entering into a LILO is the possibility that the IRS will deem the transaction a sham. LILOs have been harshly criticized as abusive tax shelters that serve only to transfer tax benefits associated with property ownership from tax-indifferent entities, which have no use for them, to U.S. taxpayers. See David P. Hariton, Response to "Old 'Brine' in New Bottles" (New Brine in Old Bottles), 55 Tax L. Rev. 397, 402 (2002) (noting one commentator's characterization of LILOs as abusive tax shelters and agreeing that LILOs "purport[ ] to create tax benefits that Congress did not intend to confer on anyone in respect of transactions that involve no business investment at all"). In 1996, the IRS issued proposed regulations that largely eliminated the tax benefits associated with LILOs; these regulations became effective in 1999. Section 467 Rental Agreements, 61 Fed. Reg. 27,834 (proposed June 3, 1996); 26 C.F.R. § 1.467-1 to -5 (2007). Although the regulations did not apply to transactions entered into before 1999, there remained a risk that the IRS would invoke generally applicable tax law principles to disallow LILO-related deductions. Despite the risk, many large financial institutions executed LILO transactions between 1996 and 1999.

B. The Transaction.

1. BB&T Enters into the LILO.

BB&T, a U.S. financial services company based in the Southeast, entered into the LILO at issue in this appeal with Sodra Cell AB ("Sodra"), the business division of a Swedish cooperative recognized as one of the world's leading wood pulp manufacturers.1 The property at issue in the transaction is a 22% interest in the pulp manufacturing equipment at one of Sodra's mills (hereinafter "the Equipment").2 As explained more fully below, the transaction, which remains on-going, involves a lease and simultaneous (but shorter-term) lease-back, followed by a series of options.

A promoter, Knight, Tallman & van Tol Capital Partners, L.L.C. ("KTV"), solicited BB&T to participate in the transaction. KTV marketed the LILO to BB&T as a "tax driven structure" that would provide significant "[t]ax savings" while eliminating economic risk through the use of defeased accounts.3 (J.A. at 173-186.)

Before entering into the LILO, BB&T performed an independent evaluation of the transaction. This internal assessment described the transaction as a "tax-driven deal" with an after-tax investment yield "largely generated by tax benefits associated with accelerated tax deductions" for rent. (J.A. at 187.) BB&T's Chief Financial Officer ("CFO") conceded that "if there were no tax benefits" BB&T would

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"[p]robably not" have moved forward with the LILO. (J.A. at 83.) The CFO claimed, however, that BB&T was "intrigued by the transaction" in part because it was "looking to grow loans and diversify [its] loan portfolio." (J.A. at 996-97.)4

As part of the process outlined in the KTV promotion, BB&T had the Equipment appraised. Deloitte and Touche, L.L.P. performed the appraisal and prepared a report estimating the equipment's useful life and fair market value, as well as the value of the interest BB&T would have in the equipment at different times.

Then, on June 30, 1997 (the "Closing Date"), BB&T and Sodra executed the transaction through a series of interrelated agreements. These agreements included, inter alia, a "Head Lease," a Sublease, a Debt Payment Undertaking Agreement ("Debt PUA"), and an Equity Payment Undertaking Agreement ("Equity PUA"). The Head Lease and Sublease govern the parties' interests in the Equipment, while the Debt PUA and Equity PUA set forth fiscal obligations.

2. Property Interests - -the Leases.

Pursuant to the Head Lease, BB&T leased the equipment from Sodra for a 36-year term. At the same time, under the terms of the Sublease, Sodra leased the equipment back from BB&T for a 15.5-year period that the parties refer to as the "Basic Lease Term." In effect, the Sublease retracted BB&T's rights and obligations under the Head Lease for the duration of the Basic Lease Term, but provided BB&T a right to make an annual inspection of the Equipment.5 Sodra therefore continues to use and possess the Equipment as it did prior to the transaction. Between 1995 and 1997, Sodra made major improvements to the Equipment at a cost in excess of $125 million. After the Closing Date (between 1997 and 2001), Sodra continued to make improvements to the Equipment at a capital cost totaling $74.6 million.

When the Basic Lease Term expires on January 1, 2013, Sodra has the option to buy back BB&T's remaining interest under the Head Lease. Sodra's exercise of this option would terminate the transaction in 2013, following the close of the Basic Lease Term.

If Sodra declines this "purchase option," BB&T has options of its own. These options include (1) requiring Sodra to extend its Sublease an additional 13.3 years to April 18, 2026 (meaning the Sublease would then end 7.2 years prior to the expiration of the Head Lease)...

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